by Mike Kimel
Scott Sumner Digs Deeper
Scott Sumner criticizes my most recent post in which I indicate that Keynesian theory explains growth rates during the New Deal era better than theories proposed by monetarists.
He starts by criticizing this, which I wrote in my earlier post.
Aggregate demand was very slack when FDR took office.
FDR showed up in Washington with a plan to start spending a lot of money and thus boost aggregate demand.
The immediate effect was to convince factories they’d be running down their inventories. That boosted producer prices. It had a much smaller effect on consumer prices because everyone knew the gubmint was going to buy a heck of a lot more producer goods than consumer goods. (The government did buy some consumer goods for the various programs, plus there was a spillover effect, but as the graph clearly shows, the action was on the producer side.)
After a bit of time, the public realized FDR wasn’t planning just a one-off, but rather a sustained program of purchases of industrial items. That led them to start using some of their idle capacity, which meant not just selling the fixed amount that was in inventory. The rate of price increases thus dropped.
GDP increased the fastest rate in the United States peacetime history since data has been kept. There was a big hiccup, of course, in 1937 when the government cut back on spending for a while.
Sumner’s most important point:
Prices didn’t start rising when FDR came to Washington with spending plans; they started rising when he began depreciating the dollar. Furthermore, the weekly rise in the WPI index was highly correlated with weekly increases in the dollar price of gold (i.e. currency depreciation.) And those changes (in gold prices) were caused by explicit statements and actions by FDR. Not by fiscal stimulus, which would be expected to appreciate the dollar.
OK. Using the cool graphical tool from FRED, the Federal Reserve Economic Database, I generated this graph of the series that from what I can tell seems to be Sumner’s favorite price index when discussing the period:
Now, take a gander at the graph. And bear in mind, FDR was inaugurated in March 1933. But everyone knew what he was going to do, spending-wise, once he showed up. You can see the decline in prices halt and start reversing even before he took office.
Additionally, I’m not sure what Sumner means when he refers to the period when he says FDR “began depreciating the dollar.” There was a gold standard in place going back a long time. That means the value of the dollar was its price in gold. The price of gold was $20.67 an ounce for decades before FDR took office. It was $20.67 an ounce until the Gold Reserve Act of January 30, 1934, when the price of gold was changed to $35 an ounce. (To be precise, the government devalued the dollar on January 31, the day after the Act passed.)
The peak in the curve came in February 1934, days or at most weeks (the index isn’t that precise) after the Gold Reserve Act. Put another way… price inflation using Sumner’s measure peaked when the currency was devalued. That is precisely 100% the opposite of what Sumner wrote.
But there are some extenuating circumstances for Sumner.
(The next paragraph summarizes this story, from the memoirs of Jesse Jones.)
It seems that on October 22, 1933, Jones, the head of the Reconstruction Finance Corporation and Henry Morgenthau, then Farm Credit Administrator but soon to be Treasury Secretary, were told by FDR to come by on October 23 to devaluing the dollar by changing its relationship with gold. The three men – FDR, Morgenthau, and Jones, then went about raising the price of gold by fiat between then and January 31, 1934, when prices came to rest at $35 an ounce, a price where they stayed through 1971.
I assume that’s what Sumner is talking about. So let me modify Figure 1 to only show the period from January to October 1933.
Now, recall, Sumner’s evidence that the Keynesian view is wrong and the monetary view is right is: “Prices didn’t start rising when FDR came to Washington with spending plans; they started rising when he began depreciating the dollar.”
And yet… the graph shows very clearly that prices started to rise when FDR came to Washington with spending plans, not at the end of October when he began depreciating the dollar. As is very evident from the graph, by that time prices had already been increasing for quite a while. Wholesale prices, by October 1, were up 17% from the beginning of the year. If you started in October of 1933, it wasn’t until December of 1936 before prices increased another 17%.
The point is, Sumner is wrong. He is very wrong about when prices started to rise. He is also very wrong about why prices started to rise. And since “when” and “why” are assumptions in his model, his model is very wrong.
Now, for completeness I’m going to tackle the other thing Sumner mentioned in his post. Sumner’s critique of me includes this:
There are all sorts of the problems with the argument that the inflation of 1933-34 was caused by expectations of fiscal stimulus. First of all, it’s completely at variance with Keynesian theory, which Kimel seems to be trying to defend. Keynesian theory says demand stimulus doesn’t raise prices when there is “slack,” and there has never been more slack in all of American history than in 1933.
The problem for Sumner is that Keynesian theory is merely an extension of good old fashioned Adam Smith. Prices depend on supply and demand. You can have a good or service go up in price locally even as it goes down everywhere else.
As I noted in my earlier post, and he quoted:
The immediate effect was to convince factories they’d be running down their inventories… After a bit of time, the public realized FDR wasn’t planning just a one-off, but rather a sustained program of purchases of industrial items. That led them to start using some of their idle capacity, which meant not just selling the fixed amount that was in inventory. The rate of price increases thus dropped.
Which of course, is very consistent with the timing of events.
None of this is to pick on Sumner. There’s a whole cottage industry dedicated to advancing a story that government spending cannot have a positive effect on the economy during recessions or depressions. The problem for those trying to advance that story is that government spending does seem to correlate with positive effects during those periods. So alternate theories are proposed, and have been proposed for decades. And those theories often make a lot of sense… until you take a close look at the data.